Is Buying an Existing Business Better Than Starting One?

building vs buying a businessWould-be entrepreneurs are divided into two camps. Some entrepreneurs opt to go the startup route and start a business from scratch. They look at the fanfare and prestige associated with founders that run companies with sky-high valuations. On the other side, some entrepreneurs prefer buying existing companies and growing them. There is less fanfare with this strategy and the popular press does not write much about it. However, I think buying a business is safer, and, for many, more financially rewarding than building one from the ground up.

In this article, we cover:

  1. The sad reality about startups
  2. Advantages of acquiring a company
  3. Disadvantages of acquiring a business
  4. How are acquisitions financed?
  5. Could you qualify for acquisition financing?
  6. My startup story

The sad truth about startups

Regardless of whose statistics you believe, there is one inescapable conclusion that is common to all results: most startups fail. By the way, this statistic includes venture-funded startups. Although their failure rate is slightly better, having a venture capitalist does not protect you from failure.

This statistic leads to an obvious question. If most startups fail, why do venture capital companies pour money into them? It looks like a losing proposition. Venture capitalists (VCs) see each startup as a bet in a calculated risk. They don’t need every bet they make to be successful. Actually, they know that most of their bets will fail. VCs just need a few of their bets to do well. And if just one of their bets does spectacularly well, the VC will make a pile of money.

Now let’s look at things from the startup founder’s perspective. A founder can work only in a single startup at a time. Basically, they are betting 100% of their time and resources on the success of this new company. This is a concentrated risk. If the startup fail fails, they are out of luck and get no reward. The founder can start all over again from scratch or be left by the wayside and forgotten.

The popular press writes only about the great successes. Unfortunately, the press ignores most startup failures. This type of coverage creates a bias in the minds of many of their readers. They focus on the rewards of success and ignore the perils of failure. Consequently, some entrepreneurs believe that being a startup founder is an easy path to make a lot of money. This is not true.

Advantages of buying a business

There is an alternative to building a startup. You can become an entrepreneur by acquiring a company. Acquisitions are an attractive option for individuals who don’t want to build a company from scratch. Acquisitions have a number of advantages over building a company from scratch. Here are some of the more important ones:

1. The company has a track record

The most important advantage of buying an existing company is that it has a track record. You can review the company’s performance under different circumstances and determine if you want to buy it – or not. This knowledge minimizes one of the biggest risks of starting a company from scratch.

2. You can take a salary

As a startup founder, you may not get a paycheck for the first few years of operation. At best, you may be able to take a low salary, but only if your company is well funded. In most startups, the entrepreneur has to live off their savings while growing the company. Things are usually different if you buy an existing business that is doing well. The new owners have the option to work as employees for a salary, take company profits, or both. This option makes running the business a lot easier.

3. Acquisition financing is more accessible than getting VC funds

Getting financing to buy an existing business is not as difficult as getting VC funding. Most acquisitions under $5,000,000 are financed using Small Business Administration (SBA)-backed loans. Businesses that cannot be acquired with SBA-backed financing can still use other options such as private investors or Private Equity.

4. You can use leverage

Most acquisitions are made using leverage (i.e., debt) since few entrepreneurs can buy a company outright. In many cases, an entrepreneur can finance up to 90% of their transaction. This strategy is known as a leveraged buyout (LBO) and is common in small business acquisitions. Leveraged buyouts can increase your return on investment if things go well for the business. However, they can also eliminate any gains if things don’t go as planned. Use an LBO strategy with care.

5. The company has customers

Startups don’t have any customers at the beginning. The founder has to hire a business development team to drum up business. This activity is time-consuming and difficult. In reality, most founders grossly underestimate how difficult it is to build a client base. Acquisitions come with built-in brand recognition and customers. This is a major advantage. The previous owner had to go through the effort of launching and building the client base. The new owner just needs to keep it stable or grow it.

6. The company has systems and processes

This is one of the most important but underrated components of an acquisition. If you acquired a successful company (a good strategy), the company likely has systems and processes that made it successful. Those systems and processes are invaluable because they are the blueprints for success.

Disadvantages of an acquisition

Acquiring a company minimizes your risk of failure. However, keep in mind that it does not eliminate it. Acquisitions are not risk-free propositions. Here are some things you should keep in mind if you decide to acquire a business:

1. Due diligence is notoriously spotty

Due diligence is the process that allows the buyer to investigate the business they want to acquire. During the due diligence period, the buyer has the option to review the company’s financial statements, appraise the business/equipment, and so on. Unfortunately, due diligence is never perfect. There is always a chance your team will miss something essential and ultimately expensive.

2. Accounting is often inaccurate

Small businesses are notorious for having inaccurate accounting. This is a big problem because it prevents you from doing proper due diligence. Never rely on the financials of a potential acquisition at face value. Always verify them. Pay for a CPA or similar professional to help you. Otherwise, you could buy a non-performing business.

3. You could end up buying someone else’s troubled business

You want to avoid buying someone else’s troubled business. Unfortunately, this is always a risk when acquiring an existing business.

4. Sellers motives aren’t always clear

The seller’s motives for the transaction are important. However, sellers are not always transparent about their reason for selling. Most business listings tend to describe the seller’s reasons by using platitudes such as “Seller is retiring” or “Seller is focusing on other opportunities.” However, the true motive for the sale could be different. Buyers have to be careful and do their research. Perhaps the seller knows that something in the future may affect the company’s value and wants to cash out at the highest possible price.

How are acquisitions financed?

Most small business acquisitions are financed using Small Business Administration (SBA)-backed loans. These loans allow you to finance acquisitions of up to five million dollars. Transactions are usually funded using a combination of loans, seller financing, and a buyer’s equity injection.

In most of the transactions that we see, the buyer wants to finance as much as possible. Most SBA-backed loans allow buyers to finance up to 80% to 90% of the acquisition cost. The remaining 10% to 20% comes from the buyers as an equity injection. This type of transaction qualifies as a small business leveraged buyout.

Most acquisitions also include a component of seller financing. In most cases, seller financing has competitive terms and rates. For more details about this subject, read our previous post about using a loan to buy an existing business.

Who qualifies for SBA-backed financing?

Getting a business acquisition loan is not easy, regardless of the source. However, the SBA has a flexible program that is designed to help as many people as possible. Some of their requirements include for the buyer include:

  • Reasonable credit score (around 650)
  • Ability to contribute a 10% to 20% equity injection
  • Three years of personal taxes
  • Personal financial statement
  • Management experience

The target company and transaction must also meet some requirements. They include:

  • Must be profitable
  • Must be able to pay the loan back out of cash flow
  • Not be in an excluded industry
  • Reasonable Debt Service Coverage Ratio (DSCR)
  • Three years of financial statements
  • Three years of tax returns

You can find more details here.

My startup story

Although I now advocate an acquisition strategy, I did not follow that strategy myself when I became an entrepreneur. Instead, I started my own company from scratch. I bootstrapped the business since its inception and continue to manage it to this day. While I love what I do, launching a startup was the riskier path. In retrospect, if I had to do it all over again, I don’t think I would follow the same strategy. Frankly, I think I would have been better off simply acquiring small businesses in the same industry and consolidating them. Here are some of the highlights of my story:

  1. My career started in technology but my startup focused in finance (an industry that was new to me)
  2. There were no investors; the venture was 100% financed by myself
  3. I did not take a salary for a couple years, so I ran my startup and worked full-time
  4. Lastly, I took some time before quitting my job

My approach was cautious, systematic, and slow. I had to learn everything from scratch – by reading books and talking to potential competitors. At times I wasn’t sure the business would make it. Looking back, I think an acquisition would have made more sense for me and would have been easier. Ideally, the acquisition would have been in an industry I knew, offered good solutions, had good processes and systems in place, and had some solid training by the seller.

Note: This article is for information purposes only and does not intend to provide financial advice. If you need financial advice, please consult a specialist.